The Benefits of Compound Returns
The compound annual growth rate (CAGR) is the average annual increase of an investment over a specified period. Compounding enables wealth to accumulate over time assuming that the investor does not withdraw any (or too much) money from his or her account.
Compounding refers to generating earnings from previous earnings. The Swiss have a saying that can apply to compounding: “For the rolling snowball to get big, the hill has to be long and the snow has to be deep.” When you invest, you earn money on your original investment contribution (or principal) and you also earn money on the earnings. Over time, the growth of your investment can accelerate because of the earnings. The effect of compounding earnings over long periods dwarfs additional contributions; thus, small differences in the rate of growth matter significantly.
Rule of 72
The “Rule of 72” is commonly used to illustrate the benefits of compounding. This mathematical rule states that in order to find the number of years required to double your money, divide the expected compound annual growth rate into 72. So, an investment expected to grow at an annual rate of 6% will take approximately 12 years to double in value:
72 ÷ 6 = 12 years
An investment expected to grow at an annual rate of 12% will double in value in approximately six years:
72 ÷ 12 = 6 years
Maximize Your Contributions
Maximizing your contributions is important for an employer-sponsored plan, such as a 403(b)—especially if your plan sponsor matches contributions. For example, if you earn $35,000 per year and consistently contribute just 3% of your annual salary to a 403(b) plan (about $40 every two weeks), you will accumulate more than $16,000 over 10 years (assuming an 8% compound annual growth rate on the investment). If your plan sponsor matches just half of that 3% annual contribution, the amount you accumulate would grow to more than $24,000!
Although the effects of compounding may be difficult to understand in the short-term, the power of compounding is revealed over longer holding periods. It can be a powerful tool to build wealth for disciplined, long-term investors.
The Average Investor May Benefit from the General Board’s
Multiple Asset Fund
Fidelity Investments, the nation’s No. 1 provider of workplace retirement savings plans, released a study in November 2009 that highlighted the results of both employer and employee actions taken through the third quarter of 2009. Fidelity based its conclusions on more than 11 million participant accounts in employer-sponsored retirement plans for which Fidelity is the record keeper. As of September 30, 2009, Fidelity concluded that participants who made their own investment decisions earned annualized median personal rates of return of 3.2% and 1.9% over the past five and 101 years , respectively. During that same period, a participant who held the General Board’s broadly diversified Multiple Asset Fund would have earned compound annual growth rates of 5.4% and 5.3%, respectively. The differences in the aforementioned returns over 10 years are meaningful—3.4% can make a significant difference in an individual’s retirement fund.
| Initial Deposit |
Compound Annual Rate of Return |
Future Value after 40 years |
| $10,000 |
7.0%2 |
$149,745 |
| $10,000 |
3.6% |
$41,152 |
| Difference |
3.4% |
$108,593 |
As the chart shows, compound returns can have a dramatic affect on the growth of even a single lump sum deposit. It is no surprise that the power of compounding has been referred to as the “eighth wonder of the world.”
1 The personal rate of return Fidelity used was based upon a calculation of an account’s investment time-weighted performance during a given period of time and excludes contributions, withdrawals, loans and certain other types of account activity made either by the participant or plan sponsor.
2 The compound annual rate of return of 7.0% represents the General Board’s long-term expected return assumption, and is provided as an example. Actual returns may be higher or lower.
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